Commentary

Cyprus is euro zone’s very own Lehman moment

Commentary: Needlessly introducing new fear chokes off bull market

By

MatthewLynn

LONDON (MarketWatch) — Only a few days ago, the markets were looking in good shape — indeed in better shape than they have at any time since the crash of 2008.

Japan was coming back to life. The Dow
DJIA, -0.67%
was recovering its highs of five years ago. Some of the European markets were bouncing up again, and gold was falling in value as investors decided the economy was getting back to stability, and perhaps even a normal level of growth.

And then? The euro-zone crisis flares up again. In Cyprus, euro-zone finance ministers meeting late on a Friday night decided to impose a levy on all bank accounts in the country as part of a bailout agreement for the island.

For the sake of 5.7 billion euros — a sum so small it would be an insult to peanuts to compare it to a packet of the salty nuts — the people running the single currency put the recovery in jeopardy.

It was a “Lehman moment” — a tiny decision, with huge consequences. And the euro zone looks set to keep lobbing those moments at the market, choking off every potential bull run.

The proposal to impose a levy on deposits in Cyprus threatened a run on the banks right across Europe, leading to a potential catastrophe for the global economy.

After all, if they imposed a levy on deposits in Cyprus, why not pull the same trick in other floundering European countries? Would anyone really want to have money in a Portuguese, Spanish, Italian, or indeed a French bank after that fateful step was taken? It might easily be confiscated if those nations needed to be rescued.

Bloomberg News/Landov

A sign hangs above a Bank of Cyprus branch in Nicosia, Cyprus, on Tuesday.

True, there were few immediate signs of queues forming outside banks in Madrid or Milan on Monday or Tuesday. Still, the seed of doubt about whether those accounts are safe or not has been planted and will now be impossible to remove. Whether the bank run is in fast- or slow-motion does not in the end make much difference. If deposits flee out of countries over the next weeks and months, banking systems will crumble and economies will suffer.

There are respectable arguments to be made on both sides. No one disputes that the Cypriot banking system needed bailing out, largely because of the huge losses it had made in Greece. The issue was who would pay for it.

The Cypriot government couldn’t afford it, and it can’t print money. The rest of the euro zone didn’t want to pay for a bailout that protected a lot of dodgy Russian money. So there is something to be said for forcing depositors to take some of the risk, because that way they might think harder about which banks were safe and which were not, rather than just assuming central banks and governments will always come to the rescue.

Against that, it is clearly unfair to penalize ordinary Cypriot savers.

The levy punishes the prudent with savings in the bank — a point the Cypriot government has recognized by exempting accounts of less than 20,000 euros. It drains money out of the economy. It encourages everyone to keep their savings stashed under the mattress at home rather than putting it in the bank where it might actually be lent out to people. And worst of all, it spreads the fear that no bank is safe — and fear is the one force that no economic system can withstand.

So you could debate whether the right decision was made in Cyprus. What you can’t argue is that the measure was worth the risk.

The Cyprus levy would raise a mere 5.7 billion euros. It’s a paltry amount. Indeed, the entire Cypriot economy amounts to a mere 0.2% of the euro zone. The entire nation could be bailed out several times over without imposing any serious costs on its partners in the single currency.

In that sense, the decision was a “Lehman moment” for the markets. Why? Because when the U.S. authorities were faced with the choice of bailing out the Wall Street bank in 2008, they decided it was not worth the moral hazard involved. They reckoned it was better to let it go bust than allow a bunch of wild, over-paid investment bankers to pass their losses onto the state.

As it turned out, that was a big mistake. After Lehman, we had the credit crunch, and a five-year global depression. If the clock could be re-wound, there is no doubt those same regulators and politicians would give Lehman the few billion it needed to stay afloat. It would have been cheap at any price.

Likewise, Germany and France decided it was better to impose some costs on bank creditors than let them think they could get bailed-out for nothing. The trouble is, euro-zone finance ministers have no grasp of how the markets work. They have not understood how interconnected they have become, or how relatively small events can have big consequences if they send out the wrong signals.

Now they have made it clear that no bank deposit in the euro zone is safe, and they shouldn’t be surprised if money starts to leave the continent. They might be backpedaling furiously now, looking at ways to protect small savers. But the damage has been done.

If the officials running the euro zone can’t get to grips with how markets work, the bull market is not going to get any traction. The world economy may well steadily improve, employment will rise, debt may come down, and corporate profits power ahead. But the euro zone will keep chucking Lehmans into the mix.

Every time equity markets start to rise, there will be another catastrophe in Europe and they will start to wobble again.

The result? The bull market is never going to have a chance to get going — at least until the euro crisis is finally resolved with the partial dismemberment of the single currency or a fully-fledged fiscal and political union between its members.

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